October 21, 2020 - “Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.” – John Williams, President of the Federal Reserve Bank of New York.

Interestingly, all three issues – LIBOR, death and taxes – were involved in the Treasury Department and IRS’s “Revenue Procedure 2020-44, which was released on October 9, 2020. The procedure describes how a modification of a debt agreement to include LIBOR fallback language would not result in a deemed taxable exchange of the instrument (i.e., a safe harbor). We discuss the high level takeaways and the hairy details below.

The bottom line (in a truly non-legal read): If a loan or CLO adds ARRC hardwired fallback language without any changes – or only with necessary modifications, which are narrowly defined in Section 4.02(3) – then it can take advantage of the safe harbor offered by the revenue procedure. This would mean that the addition of such hardwired fallback language would not result in a deemed taxable event.

The bad news: Very few CLOs and loans are using exact ARRC language in their hardwired fallbacks.

The better news: It is still possible to avoid a deemed taxable exchange of loans and CLOs that do not meet the Treasury’s criteria of using strict ARRC fallback language, but that will require some additional testing or steps.

The hairy details:  The revenue procedure describes a safe harbor that would permit a modification of a debt agreement to add LIBOR fallback language without resulting in a deemed taxable exchange. The procedure states very clearly (in footnote 2) that an “amendment approach” to LIBOR fallback language would not qualify for the safe harbor. Instead, it is critical to use the syndicated loan hardwired fallback language dated April 25, 2019 or June 30, 2020, the bilateral hardwired or hedged fallback dated May 30, 2019 or August 27, 2020, or the securitization hardwired fallback language dated May 31, 2019.

In addition to using the ARRC hardwired fallback language, the revenue procedure provides only for modest modifications, including: i) changes to make the contract legal or legally enforceable in a relevant jurisdiction, ii) changes that cannot affect the operation of the modified contract and iii) deviations to add, revise or remove technical, administrative or operational terms if they are reasonably necessary to adopt the fallback (e.g., “Benchmark Replacement Conforming Changes”). Cadwalader, in their Brass Tax publication, noted that these modifications are quite narrow and generally would exclude changes such as shorter form language, a different rate waterfall or a later conversion to a term-SOFR (e.g., a “flip forward” or “climb the waterfall” feature). These are features that have been used or contemplated in hardwired fallbacks in the loan and CLO space.

On the positive side, Cadwalader adds, just because a taxpayer uses LIBOR fallback language that falls outside the safe harbor does not mean that the fallback may be a deemed taxable exchange. The taxpayer could either look to whether i) a material modification of the contract occurred by the operation of the terms of the agreement or ii) the instrument’s yield changed by less than 0.25% or 5% of the unmodified yield. In addition, the taxpayer can determine whether the modification satisfies the requirements of the 2019 proposed regulations.

Importantly, the Treasury Department and IRS note that additional relief could be released in the future and specifically solicit comments on the scope of the permitted deviations from the ISDA or ARRC language, including the need for additional categories of deviation in that list. Market participants that have or plan to adopt ARRC language with modifications that do not fall in one of the enumerated categories should consider submitting comments in this regard before the comment deadline of December 31, 2022.

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